The Stock Market Loophole That Screws The Little Guy

The American Dream is the small-business dream: Work hard and achieve success. But the American promise is one of shared prosperity, as encapsulated in the idea that “what is good for General Motors is good for America.” And for that, you need big businesses to be listed on the stock exchange, owned by the public at large.

The American promise is an imperfect one, of course, and rings hollow to individuals and groups who have found themselves with little or no ability to build wealth or savings. But in its own capitalist way, the public stock market is democratic: Anybody with money can buy into it and share in its risks and rewards. Whether you’re investing $5,000 or $500,000, the stock market has aspired to be a level playing field for the past 85 years, refereed by the watchful eyes of the SEC.

Felix Salmon (@felixsalmon) is an Ideas contributor for WIRED. He hosts the Slate Money podcast and the Cause & Effect blog. Previously he was a finance blogger at Reuters and at Condé Nast Portfolio.

Consider one way that hundreds of thousands Americans have made money recently: Anybody who bought Twitter stock five months ago, and simply held on to it, would have doubled that money.

When you buy Twitter stock on the open market, none of your money goes to the company itself. Investors bought $1.8 billion of Twitter stock when it went public in 2013, and that was the last time the company raised any money by selling shares. Since then, Twitter stock has risen and fallen based on demand from investors, in a process that economists like to call price discovery, but which is more intuitively understood as simple speculation. Investors buy stocks they think are going to go up, sell stocks they think are going to go down, and try to make money doing so.

In recent years, however, investors have started playing the same game by buying shares in private companies, in similar hope of a massive payday. While anybody can buy Twitter stock today, that wasn’t true in 2011, when Andreessen Horowitz reportedly built up an $80 million stake in the company by buying shares from existing shareholders. Those insiders were not allowed to simply sell their shares in public, and the list of buyers they were allowed to sell to was very short. What’s more, the price paid was not made public, thereby defeating the main social purpose of stock markets, which is price discovery.

It’s important to note that Andreessen Horowitz was not funding the company and providing money for it to grow, in the way that venture capitalists normally do. The $80 million was a speculative secondary-market investment in the stock, not unlike anybody playing the market today.

In 2011, then, if you wanted to speculate on Twitter stock, you needed to be a well-connected insider. Now that Twitter’s a public company, by contrast, anybody can do it—at prices roughly nine times more than Andreessen Horowitz paid back then. If you want to play the game of buying low and selling high, your ability to buy low is clearly greater if you’re among the select few able to purchase shares when a company is still private.

If you want to play the game of buying low and selling high, yourability to buy low is greater if you’re able to purchase shares when acompany is still private.

While secondary-market speculation on private-company share prices was rare in 2011, the rise of the unicorns means that it’s much more common today, and equally unedifying. The amounts can be much bigger, too: Softbank spent $1.3 billion buying up WeWork stock from insiders in 2017—without having to compete against other bidders. More recently, Travis VanderZanden, the founder of Bird, seems to have sold more than $40 million of his own stock to venture capitalists, less than a year after founding the company. This isn’t money the company is raising. Rather, it’s a personal sale, to venture capitalists who are hoping that the value of that stock will rise significantly.

Another example is Josh Kushner, Jared’s brother. His Thrive Capital invested $150 million into GitHub in 2015, before it was sold to Microsoft for $7.5 billion earlier this month. About $30 million of Kushner’s money was a direct investment into the company, but the vast majority of the investment, some $120 million, was pieced together, much like Andreessen Horowitz’s Twitter stake, by buying up insiders’ stock on the secret secondary market. It was Kushner’s largest and most successful investment: His purchases gave him about 10 percent of the company, which meant that he’s going to get paid out $750 million when the deal closes. Kushner’s $30 million helped GitHub get to its impressive exit; his $120 million didn’t. But insofar as the per-share price was the same, both investments were equally profitable for him.

All of these deals violate the spirit, if not the letter, of American securities law. The SEC was built on a core principle: that in the world of stock price speculation, there should be a level playing field and equality of opportunity. Rich private investors, however, most of whom are well connected in Silicon Valley, have found a loophole which allows them to buy shares secretly in private companies. And they have turned that loophole Brobdingnagian.

The SEC was built on a core principle: That in the world ofstock-price speculation, there should be a level playing field andequality of opportunity.

Historically, private companies have fallen into one of three broad groups: small businesses, which generally fund themselves with bank loans; large family-owned companies, which generally didn’t need to raise money at all; and startups, which would be funded via venture capital. When the owners of a private company wanted to sell, they either sold the whole company to a strategic acquirer or else they went public, in an IPO, and allowed anybody to buy the stock.

That system has now been upended, and even Andreessen Horowitz’s Ben Evans admits that the new system is worse. Looking at the Theranos debacle, Evans sees “the desire of generalist capital to get exposure to growth that’s moved from public to private markets,” He’s looking at Rupert Murdoch and Betsy DeVos wanting to get in on the private-market speculation game, because they can see enormous potential profits there. They know that they’re not going to be protected in the same way they would be in the public markets, but they write nine-figure checks anyway.

Investors in Theranos, of course, ended up losing most if not all of their money, but that’s not going to stop other wealthy individuals from trying to move their stock-speculation practice to the uncrowded private markets—markets which are wholly off limits to normal investors, and where prices are almost never published.

That move is entirely rational, if you’re rich and well-connected. As a rule, the smaller and more opaque any market is, the greater the opportunity it offers for outsize profits, just because you’re competing against many fewer fellow speculators.

On a societal level, however, this move is harmful. It deprives millions of Americans from enticing early-stage investment opportunities; it removes important and valuable public price signals from the commons; and it further erodes the foundations of the all-American democracy of shareholders. The weather in Palo Alto is generally lovely, but right now it could use a lot more sunlight.